FINRA 2011 Annual Regulatory and Examination Priorities

FINRA 2011 Annual Regulatory and Examination Priorities 
On February 8th, FINRA released their 2011 Annual Regulatory and Examination Priorities letter detailing regulatory developments over the last year and examination focuses for the coming year. To follow is a summary of the letter which provides information on new rules affecting broker dealers and guidance on key areas that will bear increased focus and scrutiny during a FINRA examination of the member firm.

New Rules Affecting Broker Dealers
  

Examination Priorities
The goal of FINRA examination program and guidance to its member firms is to "assess whether internal controls, supervisory systems and risk management practices properly address the matters discussed."

Fraud Detection
Member firms should spot and must investigate red flags that may indicate fraudulent behavior. FINRA Rule 4160 , February 1, 2011 - Strengthens FINRA's ability to verify independently customer and proprietary assets maintained by a member firm at a non-member financial institution.

Fraudulent Activity Associated with Customer Accounts
Maintain Supervisory Systems and AML Monitoring Systems to detect and report suspicious transactions and identifying clients who engage in high-risk activity.

High-Frequency Trading, Algorithms, Sponsored Access, Direct Market Access & Trading Pause
July 14, 2011 - Maintain effective controls over electronic order routing, and surveillance of algorithmic trading and HFT strategies. CEO must certify annually that the risk management controls and supervisory procedures comply with SEA Rule 15c3-5 and that regular reviews were conducted. There should be adequate policies in place and a pause in trading whenever the price of any covered security moves 10 percent or more from a sale in a preceding five-minute period. End on April 11, 2011.

Short Sales and Regulation SHO
Direct Market Access trading systems for their customers that were designed to block the execution of short sale orders unless a "locate" had been obtained and documented. FINRA found, however, that the firm disabled this system in certain instances and its clearing firm created a separate system for certain customers. February 28, 2011 - Regulation SHO Amendments - Implement a short-sale related circuit breaker for NMS stocks triggered by a 10 percent or more decrease in the price of the security from the security's closing price at the end of regular trading hours on the prior trading day.

Information Barriers
Concern about weak information barriers and making sure they are equipped to prevent insider trading, front running or other misuse of material and non-public information. The company-specific information provided by outside research firms in some cases may be considered material, non-public information, depending on the source and how it is disseminated.

Private Placements and Private Self-Offerings
Concern with suitability, supervision, advertising, and illegal distributions of unregistered securities. FINRA reminds firms to conduct reasonable investigations into Regulation D offerings.

Trading in Non-Public Securities
Any transaction in unregistered securities must be conducted pursuant to a valid exemption from registration requirements.

High-Yield Investments
FINRA is concerned retail investors may not consider or understand credit risk and liquidity trade-offs related to high-yield investments and that certain products bear an inverse relationship to interest rate moves and the principal is not guaranteed.

Municipal Securities
Must understand the municipal securities sold and meet disclosure, suitability, and pricing obligations. Material information must be disclosed to customers, allowing them to evaluate these investments.

Non-Conventional Investments
Focus on firms that offer structured products and riskier asset-backed securities and ensuring brokers understand risks and costs associated with these products (eg. collateralized mortgage obligations CMOs).

Exchange-Traded Funds and Notes
Marketing materials should include the material risk disclosure. FINRA is conducting targeted exams to gather information on advertising and sales literature pertaining to ETPs that are not registered investment companies.

Vulnerable Customers
Firms may not mislead customers regarding expertise and qualifications to advise on areas such as retirement planning through use of professional designations. Procedures must be in place to ensure those designations are legitimate and are not misleading - especially to ensure the protection of retired, elderly or ill customers as well as those in affinity groups that may be considered vulnerable to certain risks.

Electronic Communications and Social Media
Text messages, blogs, bulletin boards, interactive forums, social networks and Skype messaging should all be retained and supervised. This includes any electronic communication sent from a registered representative or firm to a customer/prospective customer relating to the firm's business. Prior approval of communications is required for static content. Interactive/Real-time communications can be supervised with post-review.

Consolidated Account Reports
Could mislead investors or be used to perpetrate fraudulent activity. The firm must have procedures in place to conduct due diligence on the valuation of assets prior to including them on financial account reports to customers.

Hiring and Compensation Practices
Attention to newly hired individuals, enhanced compensation packages, applicant's background, and potential conflicts.

Outside Business Activities and Private Securities Transactions
Registered persons are prohibited from engaging in any outside business activity unless prior written notice has been provided to the firm. Firm's have until June 15, 2011 to review pre-existing activities under the current standards.

Master/Sub-Account Relationships
There is the concern that Master/sub-account relationships carry the risk that the firm does not know the identity of its "customer" as required. FINRA reviews procedures for determining the beneficial ownership of each account within a master/sub-account structure.

Funding and Liquidity Risk Management
Broker dealers must have liquidity and risk management practices in place to be prepared to manage their daily operations under severe and prolonged adverse market conditions. Firms should establish a risk-limit structure, periodic stress testing and scenario analysis, and should develop and maintain a contingency funding plan.

Intercompany Transactions/Affiliate Relationships and Activities
Firms must maintain accurate books and records for affiliate transactions and perform reconciliations. These reconciliations include expense sharing, revenue sharing or other serve level agreements.

Governance and Control Over Margin Lending
The firm should have a governance process in place for approving large margin loans to demonstrate controls over margin lending. Control of risks should include assessing the type and sufficiency of collateral, credit worthiness of the borrower, valuation and liquidity of the collateral, concentrations of collateral, ability of the firm to fund the loan (liquidity risk) and other factors.